Thursday, June 25, 2009

Can pay, won't pay

HOUSE prices in America have fallen so far that as many as one in five households have mortgage debt greater than the value of their homes. In a few states, borrowers are not liable for the shortfall between an unpaid loan and the resale value of the home it is secured upon. Even where borrowers are on the hook, lenders often find it too costly to pursue unpaid debts. So some homeowners may be tempted to default and escape the burden of negative equity.

How widespread is this practice? New research* based on a survey of 1,000 homeowners suggests that one in four mortgage defaults are “strategic”—by people who could meet their payments but who choose not to. The main drivers of strategic default are the scale of negative equity, and moral and social considerations. Few would opt to renege on their mortgage if the equity gap were below 10% of their home’s value, the authors find, partly because of the costs of moving. But one in six would bail out if loans were underwater by a half.

Four-fifths think strategic default is wrong. Those in the unethical minority are four times more likely to renege on loans (allowing for other influences) when their negative equity reaches $50,000. But morality has its price. When the equity gap reaches $100,000, “immoral” homeowners are only twice as keen to walk away from their debts as “moral” ones. People under 35 or over 65 are less likely to believe that default is wrong. So are the well-educated.

Anger about bail-outs of banks or carmakers does not weaken the moral barrier to default. But people who live in neighbourhoods where home repossessions are frequent are more likely to welsh on loans. Homeowners who know someone who has defaulted strategically are 82% more likely to say they would do so, too. The likelihood of strategic default rises more quickly once the rate of local home foreclosures reaches a critical level. That hints at a vicious cycle of foreclosures that both depress home prices and weaken the social and economic barriers to further defaults. To break the cycle, policymakers need to address the problem of negative equity, not just unaffordable interest payments.

* “Moral and Social Constraints to Strategic Default on Mortgages” by Luigi Guiso, Paola Sapienza and Luigi Zingales, University of Chicago Working Paper